How Student Loans Work

Banks have been in the commercial lending business a lot longer than the U.S. government. This is both good and bad for you, the borrower. Having lent money longer, banks offer more advanced features for your loan, like automatic debit from your account. Many private lenders offer a quarter percentage point off the interest rates they charge, because it saves them money. They also offer deferments, usually around six months following graduation (more on that on the next page).

But student loans from private banks also have their downsides. For starters, you may not be eligible for one. Like traditional loans from commercial banks, eligibility for private student loans, also called alternative student loans, is based on your creditworthiness. If you have bad credit, you may not get a bank to lend to you. If this is the case, you may still be able to get a loan if you can come up with a friend or relative who's willing to cosign on the loan. Cosigning is very common for private student loans since most teenagers don't have the credit history to get a loan of such size. Be aware, however, that the cosigner's credit is just as on the hook as yours when repayment comes due.

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With private student loans, interest rates are variable. They're based on one of two indices, the LIBOR (the London Interbank Offered Rate, or the rate banks charge one another for loans) or the prime rate (the rate at which the most creditworthy people can borrow money). This rate will be added to an additional percentage margin, based on your creditworthiness. Since the LIBOR and the prime rates fluctuate, so too will the interest rates on you loan payments.

Like federal student loans, the bank will disburse funds to your school. You can usually borrow up to the full cost of tuition and fees. Unlike some federal loans, banks act blindly to any scholarship or grant money you have coming your way to pay for tuition. So you can borrow all of the money you need to attend, even if you don't require that much. Any amount left over will be disbursed to you by your school. Again, remember that borrowing money is the most expensive way to pay for an education, and private student loans are the most expensive of their kind. Be wise with how much money you borrow. A good rule of thumb is to borrow no more than the average annual salary of the job you're planning on pursuing after graduation [source: Kantrowitz].

On the next page, we'll look at how interest may or may not accrue, depending on whether your loan is subsidized.